What Is a Home Equity Loan vs. Cash-Out Refinance?

By admin / May 21, 2024

Your home is a great investment filled with financial opportunities. As your home builds equity, this investment can move beyond its four walls. You can use your home’s equity to fund other financial goals or fill the gap when emergencies arise.

If you’re thinking about tapping into your home’s equity, chances are you have heard of various loan options. Maybe you are comparing a home equity loan vs. cash-out refinance. Both are viable options, so how do you know which one is right for you? Each type of loan comes with different risks and rewards. Let’s unpack these differences so you can determine which one will best fit your situation.

What Is a Home Equity Loan?

A home equity loan is essentially a second mortgage in which you borrow money against the equity in your home. The amount of home equity you have is determined by your home’s current market value minus how much you still owe on your mortgage. Typically, lenders allow you to borrow up to 80 to 85 percent of your home equity as a lump-sum loan with a fixed interest rate.

A lender will consider a prospective borrower’s credit score and loan-to-value (LTV) ratio to calculate the risk of default. To calculate your LTV, divide the combined value of all your loans by the total value of your property. Typically, the lower the LTV and higher the credit score, the less risk a borrower poses for a lender; this is typically rewarded with better interest rates and higher loan offers. To qualify for more competitive rates, aim to keep your LTV around 80 percent and your credit score at 620 or higher.

How Does a Home Equity Loan Work?

Home equity loans work the same as a conventional mortgage. Once approved, you receive the cash from the loan. Then you make regular, fixed payments as determined by the loan’s repayment term. These payments are in addition to your original mortgage payments. Loan terms vary from lender to lender; however, they commonly range from 5 to 30 years. Monthly payments cover both the principal and the interest.

In a home equity loan, your home serves as collateral. If you are unable to repay the loan in full, your home can be sold to cover the remaining debt. These types of loans can be easier to budget for since the rates are fixed, making the monthly payments predictable. Still, it’s important to consider carefully your ability to repay the loan before signing on the dotted line.

What Is a Cash-Out Refinance?

Another option for tapping into your home’s equity is a cash-out refinance. Turn your home’s equity into cash by replacing your current mortgage with a new, larger mortgage. The difference between the amount of the new loan and the remaining balance of the original mortgage is paid to you in cash at closing. Since this is a new loan, you will also begin a new loan term with a new monthly payment amount. Typically, since the loan is larger, your payment will be as well. Be sure to consider this when planning your budget.

Similar to a home equity loan, your credit score will be considered by the lender when determining the interest rate and loan amount. Lenders may also look at your debt-to-income (DTI) ratio. To determine your DTI, divide your total monthly debt by your gross monthly income. Aim to keep your DTI no higher than 45 percent for competitive rates. Since requirements vary from lender to lender, it’s important to shop around and compare potential rates.

How Does a Cash-Out Refinance Work?

To qualify for a cash-out refinance, you typically need to have paid off at least 20 percent of the appraised value of your home. The amount you qualify for will depend on how much equity you’ve built up.

How much cash can you borrow? The maximum amount varies according to the type of property you own and the parameters set by your lender. However, in general, the threshold is 80 percent of your home’s value. Once you are approved for a cash-out refinance, your lender will open a new mortgage and pay off what you still owe on your current mortgage, and you keep the difference to use however you like.

Home Equity Loan vs. Cash Out Refinance: Which One Is Right for You?

When might a home equity loan be advantageous compared to a cash-out refinance and vice versa? Let’s look at the pros and cons of each:

Pros of Home Equity Loan

  • Fixed interest rate
  • Predictable, consistent monthly payments
  • Typically lower interest rates than personal loans and credit cards
  • Larger loan sums than many personal loans
  • Long repayment plan options
  • Easy source of cash for large expenses

Cons of Home Equity Loan

  • Minimum equity requirement
  • Risk of negative equity and owing more than your home is worth
  • Closing costs
  • Risk of foreclosure
  • Repayment is in addition to original mortgage

Pros of Cash-Out Refinance

  • Take advantage of lower interest rates if credit score has improved or market interest rates have dropped
  • Qualify for new loan terms that may be a better fit than original mortgage
  • Consolidate to one loan for easier repayment
  • Access more funds for large expenses

Cons of Cash-Out Refinance

  • Foreclosure risk since the home is collateral
  • Larger monthly payments with a new, larger loan amount
  • Slower to process than most personal loans
  • Closing costs

The Bottom Line

Both loan options are great for one-time, large expenses, such as funding a wedding, paying for school or medical bills, creating an emergency fund, consolidating debt, or improving the value of your home with renovations and repairs.

Cash-out refinancing may be ideal if interest rates have dropped and you plan on living in your home for at least a year—this will give you time to make up for any closing costs you pay. A home equity loan, on the other hand, is easier to qualify for if you have a lower credit score. It can be used for any purpose, including raising the value of your home, and can give just as much equity access as a cash-out refinance.

When assessing which one is right for you, consider how long you plan to live in your home, how much equity is available, and what you need the money for. If you are unsure, speak with a loan expert. They can help guide you to the best loan option for your unique circumstances.

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